Benefits of Tax Loss Harvesting

Every investor has the same goal for their portfolio: To increase in value over time. Of course, this doesn’t happen in a linear fashion. A well-balanced investment portfolio will consist of a myriad of individual securities, some of which will have decreased in value. Having losses in your portfolio is an unavoidable reality of investing, but there’s a strategy of managing these less fruitful positions to help lower the tax burden of their more successful counterparts. It’s called tax loss harvesting.

What is Tax Loss Harvesting?

Tax loss harvesting is a strategy aimed at lowering the overall tax liability of your portfolio. Any securities you sell for a profit are subject to capital gains taxes. For example, if you purchase $10,000 of a stock or mutual fund and sell it for $15,000 a few years later, that $5,000 gain will be taxed. This is where tax loss harvesting comes into play. Say you purchased another stock or mutual fund for $10,000, but it has decreased in value and is sold for $7,000. That $3,000 loss is subtracted from your $5,000 gain, meaning your tax liability has gone down to $2,000. This can be especially beneficial in short-term investments (securities held for less than one year) as those gains are taxed at ordinary income tax rates.

Other Benefits of Tax Loss Harvesting

It’s not just a strategy for counterbalancing gains. If your losses in any given year are greater than your gains, up to $3,000 can be deducted from your ordinary income, reducing your income tax bill. If your losses are greater than $3,000, you can apply the excess to future tax years. A strategy of periodically selling losses can result in a substantially lower tax burden over time, and if those savings are reinvested into your portfolio, the gains can be even greater!

Tax Loss Harvesting in Practice

One common way to harvest losses is to use the funds to purchase a similar security. Let’s say you have a tech stock that you’ve decided to sell for a loss as part of your harvesting strategy. You can take the proceeds of that sale to purchase a different tech stock, allowing you to both take the loss for tax purposes while keeping the allocation of your portfolio largely intact. There are restrictions with this strategy, namely an IRS regulation called the Wash Sale Rule. It states that if you sell a security for a loss and repurchase it (or a “substantially identical” security) within 30 days, the loss can no longer be deducted.

Tax loss harvesting is often done at the end of the year, when it’s easy to see the exact gains or losses a portfolio has undergone. It can also be done during regular rebalancing, when significant selling and buying would already be taking place. Some even choose to do it proactively throughout the year as individual positions fluctuate in value.

Since retirement accounts such as 401(k)s or IRAs don’t incur capital gains taxes, tax loss harvesting isn’t an applicable strategy. However, for non-retirement accounts it remains a lucrative way to manage your tax liability.